Carried Interest Should Be Disclosed on Tax Forms, and to Private Equity Investors

By Victor Fleischer

April 7, 2015

Writing in The Hill, the economist Eileen Appelbaum argues that private equity funds should be required to disclose on the tax return the partnership files for informational purposes the amount of carried interest paid to the general partner. Carried interest is the percentage of an investment fund’s profits — typically 20 percent — paid to the fund’s managers as incentive compensation.

It’s a terrific idea. Under current law, there is no separate tax category for carried interest. Instead, all partners report their distributive shares of partnership income, the character of which is determined at the partnership level.

If the fund has held capital assets for more than a year, the end result is that the managers are partly compensated for their labor efforts with allocations of long-term capital gains, which are taxed at a lower rate than ordinary income. But because managers often invest some of their own money in their fund alongside other investors, it is impossible to tell from tax data alone how much of a fund manager’s capital gain is attributable to a return on financial capital and how much is compensation.

A clearer picture of carried interest would be helpful for policy makers, and not just on the issue of taxing carried interest. Economists use tax data to estimate trends in income and wealth, and there is no reliable way to estimate how much of the increase of income inequality in the United States is attributable to disguised payments for managers’ work that are characterized as capital gains for tax purposes, as carried interest often is.

Disclosure of carried interest would also clear up a thorny point of contention in the carried-interest debate. Proponents of the tax advantage for carried interest argue that changing the rules wouldn’t raise much money. Indeed, economists at the Joint Committee on Taxation have estimated that taxing carried interest at ordinary income rates would raise less than $2 billion a year.

But the revenue estimate of $2 billion a year seems low by an order of magnitude, considering that the alternative asset management industry has over $5 trillion in assets under management.

Real estate, venture capital, private equity and hedge funds all rely on carried interest as a major component of executive compensation. The four biggest publicly traded private equity firms alone — Blackstone, Apollo, Kohlberg Kravis Roberts and Carlyle — reported over $12 billion in carried interest from 2008 to 2013. A 20 percent tax increase on that amount would have yielded over $2 billion in tax revenue just from the owners of those four firms.

Requiring asset managers to report carried interest on the partnership’s informational tax return would allow the Joint Committee on Taxation to produce a more transparent and accurate estimate of potential income. And we could better understand the effect of a tax change on the managers of different asset classes and fund sizes.

Disclosure of carried interest would benefit investors as well. Investors, of course, know their return, net of fees, at the end of the day. But even sophisticated investors have trouble understanding what portion of a manager’s pay is attributable to performance-based measures like carried interest.

The calculation of carried interest follows a clause in the partnership agreement, known as the waterfall, which dictates how much each partner is entitled to receive when a fund sells an investment, receives a dividend payment or otherwise generates income.

In simplest form, a waterfall provision might provide that investors get all their money back, plus an additional amount known as a hurdle rate, before the fund manager starts to receive a 20 percent share of any profits. But every partnership agreement is different. Hurdle rates vary. The general partner sometimes gets an extra percentage, known as a catch-up amount, after clearing the hurdle rate.

Sometimes, carried interest is calculated on a fundwide basis. Other times, it is earned on a deal-by-deal basis, with a portion held back in escrow in case of poor performance by the fund later on. The carry percentage may change as different hurdles are cleared. Any single institutional investor, with investments in multiple funds across various sectors, is at an informational disadvantage compared with each individual fund’s managers.

You would expect the nature and amount of fees to be disclosed clearly on financial statements prepared by the fund’s accounting firm. But accounting firms vary in their practices, and large institutional investors, afraid of losing access to elite fund sponsors, have been reluctant to push too hard for transparency. Requiring carried interest to be reported on a tax form would professionalize the practice and allow investors to make better comparisons across funds.

The administrative burden would be trivial. For tax disclosure purposes, carried interest could be defined simply as any allocation of income to the general partner made pursuant to the waterfall provision of the partnership agreement. Every fund, whether in real estate, venture capital, private equity or distressed debt, has to make this calculation every year in any event.

Adding an extra box to the partnership’s information return costs almost nothing. But the knowledge we would gain would be valuable, not just as a window into the murky world of private equity fee structures, but also to help us understand a significant source of income inequality in the 21st century.

Victor Fleischer is a professor of law at the University of San Diego, where he teaches classes on corporate tax, tax policy and venture capital and serves as the director of research for the Graduate Tax Program. His research focuses on how tax affects the structuring of venture capital, private equity and corporate transactions. Twitter: @vicfleischer